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LONDON (Reuters) - Lloyds warned of a "long and difficult" path to economic recovery as it set aside an extra 375 million pounds to compensate people mis-sold insurance, but cheered investors with lower bad debts.

Lloyds (LLOY.L), 40-percent owned by the government after a bailout during the 2008 financial crisis, said on Tuesday it was making progress in reducing its loan book, cutting costs and reining in bad debts - all key parts of its recovery plan.

But its planned sale of 632 branches is dragging on, underscoring the tough market facing sellers of British banking assets, and it struck a downbeat tone about the UK economy, which tipped back into recession last quarter.

"We think that the economy will be reasonably flat this year, but it is going to be a long and difficult recovery," Chief Executive Antonio Horta-Osorio said.

"We expect it to recover to growth in 2013 and expect unemployment to peak at close to 9 percent by early next year."

Lloyds said it made a first-quarter statutory pretax profit of 288 million pounds, down from 316 million in the previous quarter, but significantly better than a 3.5-billion-pound loss in the first quarter of 2011.

Britain's biggest retail bank in terms of customers said it was taking an extra 375-million-pound provision to cover compensation for the mis-selling of insurance products following a spike in complaints received in February and March.

British banks have set aside billions of pounds after losing a court case on the way they sold payment protection insurance to millions of customers.

Lloyds had already set aside 3.2 billion pounds last year, which analysts thought was conservative. Rival Barclays (BARC.L) also increased its provision last week.

BRANCHES DISPOSAL DRAGS ON

Lloyds said last week it might start talks with new banking venture NBNK (NBNK.L) about its planned sale of 632 branches after an exclusivity period with The Co-op ended. It is also considering an initial public offering for the branches.

"At the moment we have three options on the table," Horta-Osorio told reporters.

He ruled out the sale of the group's insurance arm Scottish Widows, dismissing reports of a possible deal.

Bad debts fell 36 percent from a year ago to 1.7 billion pounds and the bank cut its non-core assets by 12.4 billion pounds in the quarter, shrinking its bad loans faster than expected.

At 8:55 a.m., Lloyds shares were up 1.8 percent at 31.58 pence, with Oriel analyst Mike Trippitt relieved the bad debt charge was not as bad as feared.

Loans as a percentage of deposits fell to 130 percent at the end of March, from 135 percent at end-December, and the bank said it had reduced its target to 120 percent.

The banking net interest margin - the difference between what Lloyds receives in interest and pays out, a key revenue driver - fell to 1.95 percent from 1.97 percent in the previous three months and 2.16 percent a year ago.

The bank had warned the margin was under pressure due to higher funding costs, and said that guidance was unchanged.

Stripping out the provision for payment protection insurance, some 108 million pounds of costs linked to the branches sale, and other one-off items, Lloyds said its profit was 628 million pounds, from 284 million a year ago.